Deep Discount Cigarette Share Gains Elevate Pricing Concerns

August 1, 2018 04:01 AM GMT Tobacco Deep Discount Cigarette Share Gains Elevate Pricing Concerns Deep discount share increased 70 bps in 2Q18. Widening Marlboro price gaps and MO share losses (-70 bps in 2Q18) could pressure its strong net pricing realization, adding another complexity to its growth algorithm. We estimate a 1% reduction in net pricing growth represents an 1.5% EPS headwind. US cigarette Deep Discount market share momentum is accelerating: US Tobacco is facing increasing competition from the Deep Discount US cigarette segment, which increased market share in four out of the last five quarters. This is an inflection from steady Discount segment market share declines in the prior 16 quarters (4Q13-2Q17), and is of some concern as smokers are trading down in a healthy consumer environment and because it is occurring despite MO's stepped up investment spending (PM USA OCI -2.9% in 1H18). Most recently, Deep Discount market share increased 70 bps YoY in 2Q18, an acceleration relative to +40 bps average share gains over the prior four quarters. Discount segment share growth has been largely driven by Liggett's aggressive pricing on Eagle 20's, contributing to Liggett's 30 bps of market share gains over the last year. In contrast, the major manufacturers' discount brands lost 60 bps of share in Q2, including Altria/BAT down 30/20 bps. There is a history of different brands going for share and then monetizing market share through ultimate price hikes. Widening Marlboro price gaps could pressure net pricing realization: Deep Discount pricing activity historically tends to be cyclical, but recent widening Deep Discount price gaps could make it more difficult for MO to sustain its strong net pricing realization (+5.8% in 2Q18) while simultaneously stabilizing Marlboro market share performance. Marlboro price gaps versus deep discount brands have widened at an accelerating rate over the last three quarters, following a period of consistently narrowing price gaps over the prior 20 quarters and are weighing on MO's market share (-70 bps YoY in Q2). During 2Q18, Marlboro s average retail price was at a 30.8% premium to the lowest price discount brands (vs. 29.4% in 2Q17), expanding +140 bps YoY (vs. +76 bps YoY in 1Q18). Historically, there has been a -0.65 correlation between the YoY change in price gaps and MO's market share (see Exhibit 7). If Deep Discount pricing remains aggressive, we see potential for greater MO promotional activity behind stabilizing market share. To date, we have not seen any evidence of pricing pressure (MO +4.7%/5.6% in 1Q/2Q18) and we are modeling solid 4.6%/4.0% net pricing realization in 2018/2019. For context, a 1% reduction in our net pricing forecast, with a corresponding 30 bps benefit to volumes (0.30 elasticity), would reduce our 2019 EPS estimate by ~1.5%. MORGAN STANLEY & CO. LLC Pamela Kaufman, CFA EQUITY ANALYST Pamela.Kaufman@morganstanley.com Tobacco North America IndustryView +1 212 761-7151 In-Line Exhibit 1: Discount segment market share turned positive in the last three quarters following consistent declines Exhibit 2: MO promoted Marlboro in 2012 following weak share performance in 2011 Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factor in making their investment decision. For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report. 1

Putting weaker share into context: The last time Marlboro consistently lost market share (2011), MO responded with meaningfully less pricing (2012) and resulting in slower PM USA EBIT growth (2012-13): In 2011, MO volumes and Marlboro share (-80 bps YoY) were under pressure due to a difficult cigarette operating environment driven by a weak economic backdrop for lower income smokers, faster secular cigarette volume declines, and accelerated competitor (Lorillard) volume/share growth. This period was followed by weak net pricing realization throughout 2012, with net pricing +1.7% following 5.5% average net pricing over the prior seven years, contributing to moderating volume declines (-0.2% in 2012 vs. -4.0% in 2011) and market share growth (+60 bps in 2012), but a deceleration in PM USA operating profit growth from ~5% on average from 2009-2011 to ~3% on average in 2012-2013. Growing JUUL cigarette cannibalization could also present risk to industry pricing: We believe growing competition from JUUL could also impact the industry's pricing elasticity as a JUUL pod sells for ~$4.00 on average, well-below Marlboro's average retail price of $6.79 in 2Q18. The proliferation of viable RRP substitutes, which currently maintain a tax advantage relative to cigarettes could increase the category's historical 30% price elasticity. Exhibit 3: Discount segment market share turned positive in the last three quarters following consistent declines 2

Exhibit 4: The Deep Discount segment is experiencing strong share gains Exhibit 5: Marlboro vs. Deep Discount price gaps are widening Exhibit 6: Marlboro vs. Deep Discount price gaps widened over the last three quarters 3

Exhibit 7: Widening price gaps likely contributing to MO share losses Exhibit 8: MO promoted Marlboro in 2012 following weak share performance in 2011 4

Exhibit 9: PM USA net pricing realization remained strong in 2Q18 (+5.8%) MO.N Our $63 price target is based on 15x C2019e P/E, at a 10% discount to US Staples, consistent with the stock's 5-year historical average discount. Risks to our thesis: (i) Upside risks: Stronger net pricing and margin expansion in cigarettes; Increased shareholder returns via share repurchases; (ii) Downside risks: Growing JUUL cigarette cannibalization, increasing promotional spending, taxes & FDA regulatory risks. 5

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